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Corporate bonds offer good returns and are not as risky as many people think, says Stephen Snowden...
Corporate bonds offer good returns and are not as risky as many people think, says Stephen Snowden

The last few years have seen renewed interest in corporate bonds, especially from investors seeking more stable returns than from the stock market. More recently though, following the indifferent returns produced by some income funds, many have begun to wonder whether the future for corporate bonds looks quite so promising.

But they should not worry. Bonds - and in particular, corporate bonds - are set to play a far greater role than at present in the investment strategies of individual investors and pension funds.

Bonds offer good returns in a low interest rate environment and are low risk in comparison to equities. This - combined with a more mature and risk-averse population - are set to see corporate bonds prosper in years to come.

The reasons for this anticipated upsurge in popularity are rooted in a number of factors. First is demographics. At the moment, more than a quarter of the UK population is over 50. Government projections expect this figure to rise to around 35% in the decades to come.

Long before the recent pensions and accounting regulations of MFR and FRS17, the accepted wisdom was, for young schemes with most of the membership still working - meaning more money was coming into the scheme than was being paid out. An investment strategy involving a high level of equity investment was deemed appropriate. The money was a long-term investment for a young workforce - it could be invested for a long time before being needed to pay for benefits.

But as a scheme matures, the situation changes, because the scheme no longer enjoys a positive cashflow. It may find itself at a point where it needs to pay out more in benefits than it receives in contributions.

With many more workers closer to retirement, the straightforward strategy should be a move towards conservatism, with investments in fixed income to help meet cash outflows.

Now, with demographic changes, we are closer to the latter than the former for defined benefit pension schemes. Consequently, one would expect a shift towards fixed income instruments within pension portfolios. The emphasis becomes one of benefit protection rather than capital appreciation.

There are other factors that will serve to accelerate the shift in investor preference from equities towards bonds.

With interest rates falling in recent years, investors switched to funds that offer attractive, guaranteed returns - resulting in spectacular sales of with-profits bonds for life companies.

Life companies have become the victims of their own success - primarily because of the poor performance of the stock markets. Many insurance companies have realised that buying bonds and selling equities helps free resources, and have started switching into fixed income investments that use less capital than equity investment.

So, whether you look at the long-term demographic story or the nearer-term actions of life companies, the story is a clear one. More bonds.

The next question is - which bonds? Should a scheme invest in gilts or corporate bonds? Some council pension funds are reluctant to invest in corporate bonds because they are seen to be risky. In isolation, this is true. Worries over defaults are numerous, and high-profile defaults garner a huge number of column inches in the financial press. But consider this - if a scheme is unwilling to invest in corporate bonds, it should not be thinking of investing in the stock market.

Remember that equity is subordinate to bonds. This means that in the good times, the risks associated with equities will be reflected with high absolute returns.

But in the bad times, shareholders will take the first losses. Even a company's junk bonds rank ahead of equity when it comes to being paid off when a company folds. If you have concerns about defaults at the corporate bond level, why bother investing in even riskier equity? Logically, then, if a council pension scheme is satisfied to invest in equities, it should be more than prepared to invest in corporate bonds - whether they be investment grade or high yield.

So why not play safe, and invest in gilts? The answer here is that the investor is compensated for taking 'default risk'. Our long-term analysis demonstrates that in a diversified portfolio of triple-B rated bonds, the amount of extra yield needed to pay for default risk, when compared with a similarly-dated gilts, is 0.5%. Yet, an average triple-B rated bond has historically yielded more than 2.1% more.

Bonds are set to become even more of an integral part of investment strategy in the future, both in corporate and council pension funds. The low-interest rate environment, poor equity returns and maturing population will regenerate the demand for fixed interest investments - particularly corporate bonds - as they offer solid returns, but with minimum risk.

Stephen Snowden

Investment manager, corporate bonds, AEGON Asset Management

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